Edited version of your private ruling

Authorisation Number: 1012593611900

Ruling

Subject: Obsolete trading stock

Question 1

Is the election to value products, being trading stock of Company A Group Limited, by writing them down in accordance with the table below, warranted by obsolescence and reasonable within the meaning of section 70-50 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

1 July 2011 to 30 June 20YY

The scheme commences on:

1 July 2011

Relevant facts and circumstances

Company A Group Limited

Company A Group Limited is the largest manufacturer and distributor in the combined Australian and New Zealand markets for the product it sells.

Company A Group Limited delivers products across the value chain from commodity fixtures for residential, commercial and industrial use to high margin, customised products for use in major infrastructure and architectural projects. Company A Group Limited has manufacturing plants and warehouses in several metropolitan and regional areas in Australia to maintain a local presence and facilitate the distribution of its products.

Its products are traditionally varied in the nature of the product sources and design of the product. The product is affected by trends in the market such as colour, efficiency and architectural appeal.

For the purpose of this ruling, products refer to the trading stock of Company A Group Limited. (It is also noted that some spare parts are held as trading stock but these items represent only a minor amount (spare parts consist of components used in the manufacture process and once a model is made obsolete there is no obligation to carry spare parts.))

Project market

Approximately 50% of all products sold by Company A Group Limited are for the project market. In the context of the Company A Group Limited business the project market means the business of providing specific solutions for customers. The products supplied by Company A Group Limited for this market are products that are modified in some way to suit the requirements specified by a consultant on behalf of the customer.

The project market has sales that are spiky in nature and the industry demands shorter lead times than the actual supply chain lead times for components or finished goods. Forecasting the need for components and finished goods before project orders from customers, results in variations in the turnover of these items, particularly in the case where products are specialised or have no further purpose or value to Company A Group Limited and potential customers.

Off the shelf items

The other 50% of sales by Company A Group Limited are 'off the shelf items' and are subject to trend changes in the market. In recent years there is a trend to type A products for primarily, their longevity. The emergence of the type A product to the market is expected to increase the rate of obsolescence of other products as more customers take up the new technology.

Aging stock

Accounting treatment

Company A Group Limited analyses slow moving stock and identifies 'excess stock' for which there is a greater quantity on hand than has been sold in the past 12 months. For accounting purposes, Company A Group Limited provides for this 'excess stock' at a rate of 40% and provides for fully obsolete stock at rates of between 60% to 100%. It is up to the discretion of the inventory managers to determine what portion of the excess stock is obsolete stock or slow moving that is unlikely to be sold (As Company A Group Limited operates from multiple locations, it has capacity to store products so it is considered by the applicant that the scrapping of the obsolete product will be done when time is available).

Proposed tax treatment

For tax purposes, Company A Group Limited has traditionally treated the whole amount of the accounting provision as non-deductible. However, upon further review, Company A Group Limited is of the view that it is reasonable that trading stock that is not moving and portions of the slow moving stock on hand should be deductible for tax purposes where the likelihood of selling the slow moving stock is low.

Company A Group Limited has assessed the age of the inventory at 30 June 20XX to determine the volume of inventory that is not moving or is slow moving for the major companies of the group. It is considered by the applicant that the analysis is also applicable to smaller companies within Company A Group Limited.

Based on the analysis of sales of slow moving stock in prior years, Company A Group Limited has calculated the percentages of their slow moving stock that is unlikely to be sold or is expected to become obsolete in the near future. The percentage shown below represents Company A Group Limited's view of what is reasonable to be written down and deductible for tax purposes for the year ended 30 June 20XX and the next four income years (to 30 June 20YY):

The calculation of the percentage write down is based on expected future sales of each of the three groups of aged inventory in the table above.

Once expected future sales are calculated the value of stock that will be written off some time in the future can be determined. A buffer has been included in the calculation to allow for more sales of a product than predicted by the analysis. That is, the applicant considers that a conservative approach has been taken with regard to the proposed write down for tax purposes to ensure the percentages will be appropriate at least until 30 June 20YY.

It is expected that due to increased changes in technology, the rate of obsolescence of stock will also increase over time. To that end, the proposed write down for tax purposes is also considered conservative by the applicant.

Company A Group Limited trades in six major brands across a number of entities in the Company A Group Limited tax consolidated group which have been used in the calculation of the proposed write down percentages.

Write down methodology

Based on 20XX sales, the average percentage of sales of each aging category of inventory has been calculated as follows:

· 24 to 42 months - 25%

· 42 to 60 months - 7.3%

· More than 60 months - 6.5%

These percentages have been calculated by the applicant using the raw sales data for the year ended 30 June 20XX divided by the stock that was available at the start of the year.

Following is a summary of the methodology used to determine the future expected sales of each inventory group and therefore the percentage write off of stock listed in the table above:

24-42 months

To calculate the future sales of stock held for 24 -42 months at 30 June 20XX:

· the forecast sales for next year is likely to replicate a pattern closer to the percentage of sales for stock held in the 42 - 60 month range so an average percentage of sales for the 24 - 42 months and 42 - 60 month categories has been used

· for the following 3 years, the percentage of sales for the 42 - 60 months category has been used.

42-60 months

To calculate the future sales of stock held for 42-60 months at 30 June 20XX:

· the forecast sales for next year is likely to replicate a pattern closer to the 'more than 60 months' category, so an average percentage of sales for the 42-60 months and more than 60 months categories has been used

· for the following 2 years, the percentage of sales for the more than 60 months category has been used.

More than 60 months

To calculate the forecast sales for stock held for more than 60 months at 30 June 20XX, an estimate of sales for the next two years has been used of 5% and 3°/s respectively. These percentages have been used on the basis that the product has been purchased 5 years prior and it is expected that the percentage of sales of this stock would continue to decline.

Note that 'sales' refers to sales and usage. 'Usage' is the product that is consumed in the manufacturing process to make a finished good. A finished good is made up of many parts and it is the finished good that is sold rather than the component. To determine if the components are still being used in the finished goods 'usage' is used as a measure assuming that if the finished goods are sold, then the components will be used.

Company A Group Limited has calculated expected future sales and stock on hand using the data available for an entity within the group, Company C, to better confirm the methodology adopted to arrive at the write down percentages it has chosen.

The applicant submits that the approach taken of calculating overall write down percentages for each of the ageing categories of stock selected is considered the most appropriate and practical method.

For example, due to a significant number of the same fittings being used across both the project market and the wholesale 'off the shelf' market, and the number of products it is impractical to calculate the write-down based on market (i.e. project vs 'off the shelf') or product type.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 70-45

Income Tax Assessment Act 1997 section 70-50

Reasons for decision

Section 70-50 of the ITAA 1997 states:

70-50 Valuation if trading stock obsolete etc.

You may elect to value an item of your trading stock below all the values in section 70-45 if:

(a) that is warranted because of obsolescence or any other special circumstances relating to that item; and

(b) the value you elect is reasonable.

The purpose of the legislation is to allow a taxpayer to adopt an alternative basis of valuing trading stock on hand at the end of an income year if the taxpayer would be disadvantaged in valuing particular trading stock under one of the methods set out in section 70-45 of the ITAA 1997. The section requires the presence of obsolescence or other special circumstances and a test of reasonableness. The value that is determined under section 70-50 of the ITAA 1997 is not the value considered by the Commissioner to be reasonable, but is the value that, judged objectively, is reasonable.

Section 70-50 of the ITAA 1997 replaced subsection 31(2) of the Income Tax Assessment Act 1936 (ITAA 1936). Taxation Ruling TR 93/23 Income tax: valuation of trading stock subject to obsolescence or other special circumstances (TR 93/23) which was issued to provide guidance on the application of subsection 31(2) of the ITAA 1936, may also be applied to the application of section 70-50 of the ITAA 1997.

Obsolescence

Taxation Ruling TR 93/23 discusses the valuation of trading stock subject to obsolescence or other special circumstances. Obsolescence in this context refers to stock which is either:

a) going out of use, going out of date, becoming unfashionable or becoming outmoded (i.e. becoming obsolete); or

b) out of use, out of date, unfashionable or outmoded (i.e. obsolete stock).

Provided adequate documentation supporting the calculation is maintained, any fair and reasonable value which is calculated taking into account the factors listed in subsection 31(2) of the ITAA 1936, may be accepted for trading stock affected by obsolescence. These factors are not listed in section 70-50 of the ITAA 1997, but are still relevant in determining if a value is 'fair and reasonable' for that purpose.

Paragraph 5 of Taxation Ruling TR 93/23 sets out the following additional factors that may also be relevant, depending on a taxpayer's circumstances:

a) the age of the stock;

b) the quantities of stock on hand which are expected to be used or sold during the year and into the future;

c) the length of time since the last sale;

d) industry experience/taxpayer expertise in that kind of stock;

e) the price at which the last sale was made, the taxpayer's price list and the price at which the taxpayer is prepared to sell the stock; and

f) if the stock is spare parts:

i. the past and expected future movements compared with the potential sales; and

ii. the approximate date by which the last of those units can be expected to no

longer be in use.

Paragraph 10 of TR 93/23 provides that a standard write down for a particular class of stock will only be accepted if a taxpayer can show that the particular class of stock is always subject to the same degree of obsolescence.

TR 93/23 recommends a progressive write-down of stock if the taxpayer knows that an amount of stock will remain unsaleable but is unable to quantify that amount with any accuracy. The taxpayer should only write down that proportion of the stock which it is reasonably certain will not be sold. The valuation should recognise that a loss has already been sustained by the taxpayer. (NB paragraph 7 of TR 93/23 provides that a valuation which creates a precautionary reserve in anticipation of a loss (that is, a valuation which amounts to depreciation of the stock) is not acceptable.The applicant acknowledges (and the Commissioner agrees) that the proposed write down values presented by the applicant are not for the purpose of creating a precautionary reserve in anticipation of a loss and understands that doing so is unacceptable)

Application of TR 93/23

As stated in the facts, Company A Group Limited analyses slow moving stock and identifies 'excess stock' which is stock for which there is a greater quantity on hand than has been sold in the past 12 months. For accounting purposes, Company A Group Limited provides for this' excess stock' at a rate of 40% and provides for fully obsolete stock at rates of between 60% to 100%. Traditionally, Company A Group Limited has treated the whole amount of the provision as non-deductible for tax purposes. However, upon further review Company A Group Limited is of the view that it is reasonable that stock that is not moving and portions of the slow moving stock on hand should be deductible for tax purposes where the likelihood of selling the slow moving stock is low. In order to claim a write down of such stock for tax purposes, Company A Group Limited has assessed the age of its inventory as at 30 June 2013 to determine the volume of inventory that is not moving or is slow moving for the major companies in the group. The applicant has submitted that this assessment is relevant and can be extrapolated and equally applied to smaller entireties within the group - the Commissioner agrees.

Based on the analysis of sales of slow moving stock in prior years undertaken in accordance with the methodology described above, Company A Group Limited has calculated the percentages of their slow moving stock that is unlikely to be sold or is expected to become obsolete in the near future. These write down percentages for each of the relevant Stock Age categories of 24<42 months, 42<60 months and >60 months represent Company A Group Limited's view of what is reasonable to be written down and deductible for tax purposes for the year ended 30 June 20XX and the next four income years, that is, to 30 June 20YY.

Accordingly, the Commissioner accepts that the trading stock forming the subject of this ruling as described above satisfies the meaning of obsolescence as espoused in paragraph 4 of TR 93/23 and that the methodology proposed by the applicant to determine the written down value of the trading stock (below all the values in section 70-45) is reasonable for the following reasons:

· In line with paragraph 5 of TR 93/23 the applicant, on the basis of adequate documentation (being the raw sales data from its accounts), has examined in detail the age of the trading stock, the quantities of trading stock on hand which are expected to be used or sold during the year (being more specifically, the end of financial year 20XX) and into the future and the length of time since the last sale. It has relied on its extensive industry experience/taxpayer expertise in that kind of trading stock to come up with the proposed write down value percentages to be applied to its chosen Stock Age categories

· Selling excess stock (or slow moving stock) from the bulk production is often difficult when the stock has been on hand for several years as technology rapidly advances. More environmental, economical and innovative solutions are developed regularly and sold by Company A Group Limited in response to changing consumer demands.

· In Company A Group Limited 's case, customised products and stock left unsold are regularly rendered obsolete as they have no value to potential customers or to Company A Group Limited as spare parts.

· Company A Group Limited considers that given its constant development and sales of new energy-efficient and environmentally-friendly solutions and analyses of Company A Group Limited's slow moving stock (based on prior years), valuing its trading stock using one of the methods listed in section 70-45 of the ITAA 1997 does not present a true reflection of Company A Group Limited's taxable income for an income year.

Accordingly, the percentage write-downs proposed by the taxpayer are warranted due to obsolescence and are reasonable within the meaning of section 70-50 of the ITAA 1997.